Worker classification might seem like a simple concept, but it is one of the most critical areas where businesses face potential risk and legal exposure. Whether it’s determining whether someone should be classified as an employee or an independent contractor, or whether an employee should be exempt or non-exempt, incorrect classifications can lead to significant legal and financial consequences.

At Eckberg Lammers, P.C., we frequently assist companies with worker classification audits to ensure that they’re compliant with federal and state labor laws. In this article, we’ll explain why you should conduct an audit, what’s at stake, and how getting it right can save you from costly penalties and legal disputes.

Why Worker Classification Matters

Worker classification affects key aspects of employment, from compensation to tax obligations, and impacts how your business manages overtime, benefits, and compliance with labor laws. Misclassifying employees can have far-reaching consequences, including the potential for significant penalties, damages, and back wages.

There are two classifications that businesses often need to audit:

1. Employee vs. Independent Contractor

Classifying workers as independent contractors when they should be classified as employees is one of the most common missteps businesses make. The line between the two can be blurred, but the key is whether the worker is economically dependent on your company or truly in business for themselves.

Independent contractors enjoy a degree of freedom in managing their schedules, working with multiple clients, and operating their own businesses. Employees, on the other hand, are typically subject to more control and direction from the employer regarding how, when, and where they perform their work.

Why does this matter—and who’s watching?

Agencies such as the Department of Labor (DOL), Internal Revenue Service (IRS), and similar state departments, including Worker’s Compensation, closely monitor worker classification because it affects tax obligations, wage and hour protections, and access to benefits.

2. Exempt vs. Non-Exempt Employees

The Fair Labor Standards Act (FLSA) governs whether employees are exempt from overtime pay and there are similar state laws. Exempt employees are typically salaried and occupy managerial, executive, or professional roles, meaning they don’t qualify for overtime pay. In order for most, but definitely not all, employees to qualify as exempt they must meet both a duties test and a salary test. Failure to meet both will result in an employee losing an exemption. Non-exempt employees, on the other hand, are entitled to overtime pay when they work over 40 hours a week.

Incorrectly classifying a non-exempt employee as exempt can lead to underpayment of overtime wages, which can result in back pay and hefty penalties for your business.

The Risk of Misclassification

Failing to correctly classify workers can have severe consequences for businesses. Misclassifying employees or contractors can lead to a range of penalties and financial burdens, including:

• Back Wages: If an employee is misclassified as exempt, you may be required to pay them back overtime wages. This can amount to a significant sum, especially if the misclassification has been ongoing for years. Similarly, if you misclassified a worker as an Independent Contractor you could have back wages, including overtime if the worker could show that they worked more than 40 hours in any workweek.
• Tax Penalties: Misclassifying workers as independent contractors instead of employees can lead to fines from the IRS, back payroll taxes, and the employer’s portion of Social Security, Medicare, and unemployment taxes.
• Legal Penalties: In some cases, misclassification can lead to civil lawsuits from employees seeking unpaid wages. Some states also impose additional fines and penalties for failure to comply with state-specific labor laws.
• Unemployment and Workers’ Compensation: Independent contractors are typically not eligible for unemployment insurance or workers’ compensation benefits. If a worker should have been classified as an employee but wasn’t, your business could face liability for unpaid unemployment insurance and workers’ compensation premiums. If there was an injury, an organization has even more exposure to liability for the damages associated with that worker who was not covered by unemployment insurance.
• State-Level Penalties: Many states have their own labor laws and may impose penalties for misclassifying employees. Some states impose additional fines if a company has been found to have willfully misclassified workers.

The Importance of a Worker Classification Audit

An audit of your worker classifications is a proactive way to ensure your business is compliant with both federal and state labor laws. Of all employers who reach out for the first time to discuss contractor/employee classification, almost every time there is a suggestion that the business tweak their relationship or modify and strengthen a written agreement.

By conducting regular audits and addressing any misclassifications, you significantly reduce the risk of lawsuits and other legal disputes related to wage and hour violations, tax matters, or unemployment benefits.

How to Conduct a Worker Classification Audit

1. Review Your Current Classifications: Start by evaluating all of your workers—both employees and independent contractors—and assess whether they are correctly classified according to federal and state guidelines.
2. Evaluate the Factors: For employees, assess whether they meet the FLSA’s criteria for exemption status, focusing on job duties, salary, and level of authority. For independent contractors, consider the degree of control your company has over the worker’s job and whether they are truly running an independent business.
3. Consult with Legal Counsel: Worker classification can be tricky as the analysis consists of “shades of grey” and a “tipping of the scales” such that legal advice is often essential. A legal audit is often the best method to try to ensure that your classifications comply with all applicable laws, including federal, state, and local regulations.
4. Update Employment Agreements: If misclassifications are found, take action to correct the status and update your employment contracts or independent contractor agreements to reflect the appropriate classification. If you are in Minnesota, you will need to update your notice pursuant to Minnesota’s Wage Theft Law.

Conclusion: The Time for a Worker Classification Audit is Now

Worker misclassification is an often misunderstood and commonly overlooked compliance-trap in businesses today. It may seem like a small error, but the potential consequences—ranging from back pay to hefty fines—can be devastating. A worker classification audit is a proactive way to protect your company and avoid future headaches.

At Eckberg Lammers, P.C., we help businesses navigate the complexities of worker classification laws, conduct thorough audits, and ensure compliance. If you haven’t already conducted an audit or need guidance on correcting misclassifications, let’s talk about how we can help your business stay protected and compliant.